When you have completed your study of this chapter, you will be able to C H A P T E R C H E C K L I S T Explain how price and quantity are determined in monopolistic competition. 1 Explain why selling costs are high in monopolistic competition. 2 Explain the dilemma faced by firms in ologopoly. 3 Use game theory to explain how price and output are determined in oligopoly. 4

12.1 MONOPOLISTIC COMPETITION Monopolistic competition is a market structure in which: A large number of independent firms compete. Each firm produces a differentiated product. Firms compete on product quality, price, and marketing. Firms are free to enter and exit.

 Large Number of Firms Like perfect competition, the market has a large number of firms. Three implications are: Small market share No market dominance Collusion impossible 12.1 MONOPOLISTIC COMPETITION

 Product Differentation Product differentiation Making a product that is slightly different from the products of competing firms. A differentiated product has close substitutes but it does not have perfect substitutes. When the price of one firm’s product rises, the quantity demanded of that firm’s product decreases MONOPOLISTIC COMPETITION

 Competing on Quality, Price, and Marketing Quality Design, reliability, service, ease of access to the product. Price A downward sloping demand curve. Marketing Advertising and packaging 12.1 MONOPOLISTIC COMPETITION

 Entry and Exit No barriers to entry. A firm cannot make economic profit in the long run MONOPOLISTIC COMPETITION

 Identifying Monopolistic Competition Two indexes: The four-firm concentration ratio The Herfindahl-Hirschman Index 12.1 MONOPOLISTIC COMPETITION

The four-firm concentration ratio The percentage of the value of sales accounted for by the four largest firms in the industry. The range of concentration ratio is from almost zero for perfect competition to 100 percent for monopoly. A ratio that exceeds 40 percent: indication of oligopoly. A ratio of less than 40 percent: indication of monopolistic competition MONOPOLISTIC COMPETITION

The Herfindahl-Hirschman Index (HHI) The square of the percentage market share of each firm summed over the largest 50 firms in a market. Example, four firms with market shares as 50 percent, 25 percent, 15 percent, and 10 percent. HHI = = 3,450 A market with an HHI less than 1,000 is regarded as competitive. An HHI between 1,000 and 1,800 is moderately competitive MONOPOLISTIC COMPETITION

Limitations of Concentration Measures The two main limitations of concentration measures alone as determinants of market structure are their failure to take proper account of The geographical scope of a market Barriers to entry and firm turnover 12.1 MONOPOLISTIC COMPETITION

 Output and Price in Monopolistic Competition How, given its costs and the demand for its jeans, does Tommy Hilfiger decide the quantity of jeans to produce and the price at which to sell them?  The Firm’s Profit-Maximizing Decision The firm in monopolistic competition makes its output and price decision just like a monopoly firm does. Figure 12.1 on the next slide illustrates this decision MONOPOLISTIC COMPETITION

1. Profit is maximized when MC = MR 3. The profit-maximizing price is $70 per pair. 4. The firm makes an economic profit of $7,500 a day. 2. The profit-maximizing output is 150 pairs of Tommy jeans per day. ATC is $20 per pair, so 12.1 MONOPOLISTIC COMPETITION

 Long Run: Zero Economic Profit Economic profit induces entry and economic loss induces exit, as in perfect competition. Entry decreases the demand for the product of each firm. Exit increases the demand for the product of each firm. In the long run, economic profit is competed away and firms earn normal profit. Figure 12.3 on the next slide illustrates long-run equilibrium MONOPOLISTIC COMPETITION

1. The output that maximizes profit is 75 pairs of Tommy jeans a day. 2. The price is $50 per pair. Average total cost is also $50 per pair. 3. Economic profit is zero MONOPOLISTIC COMPETITION

 Monopolistic Competition and Efficiency The two key differences between monopolistic competition and perfect competition are that in monopolistic competition, there is Excess capacity A markup of price over marginal cost 12.1 MONOPOLISTIC COMPETITION

Excess Capacity A firm has excess capacity if the quantity it produces is less that the quantity at which average total cost is a minimum. A firm’s efficient scale is the quantity of production at which average total cost is a minimum. Markup A firm’s markup is the amount by which price exceeds marginal cost MONOPOLISTIC COMPETITION

1. The efficient scale is 100 pairs of jeans a day MONOPOLISTIC COMPETITION 2. The quantity produced is less than the efficient scale and the firm has excess capacity. 3. Price exceeds marginal cost by the amount of the markup.

In perfect competition, the efficient quantity is produced and price equals marginal cost MONOPOLISTIC COMPETITION

 Is Monopolistic Competition Efficient Efficiency requires marginal benefit to equal marginal cost. In monopolistic competition, price exceeds marginal cost, which is an indicator of inefficiency. Making the Relevant Comparison Price exceeds marginal cost because of product differentiation. But product variety is valued. The Bottom Line The bottom line is ambiguous. But compared to the alternative, monopolistic competition looks efficient MONOPOLISTIC COMPETITION

12.2 DEVELOPMENT AND MARKETING  Innovation and Product Development Wherever economic profits are earned, imitators emerge. To maintain economic profit, a firm must seek out new products. Cost Versus Benefit of Product Innovation The firm must balance the cost and benefit at the margin.

12.2 DEVELOPMENT AND MARKETING Efficiency and Product Innovation Regardless of whether a product improvement is real or imagined, its value to the consumer is its marginal benefit, which equals the amount the consumer is willing to pay. The marginal benefit to the producer is the marginal revenue, which in equilibrium equals marginal cost. Because price exceeds marginal cost, product improvement is not pushed to its efficient level.

12.2 DEVELOPMENT AND MARKETING  Advertising Firms in monopolistic competition spend a large amount on advertising and packaging their products. Marketing Expenditures A large proportion of the prices that we pay cover the cost of selling a good. Figure 12.5 on the next slide shows some estimates of marketing expenditures for some familiar markets.

12.2 DEVELOPMENT AND MARKETING

Selling Costs and Total Costs Advertising expenditures increase the costs of a monopolistically competitive firm above those of a perfectly competitive firm or a monopoly. Advertising costs are fixed costs. Advertising costs per unit decrease as production increases. Figure 12.6 on the next slide illustrates the effects of selling costs on total cost.

12.2 DEVELOPMENT AND MARKETING 1. When advertising costs are added to … the average total cost of production, … 3. … average total cost increases by a greater amount at small outputs than at large outputs.

12.2 DEVELOPMENT AND MARKETING 4. If advertising enables sales to increase from 25 pairs of jeans a day to 125 pairs a day, it lowers the average total cost from $30 a pair to $20 a pair.

12.2 DEVELOPMENT AND MARKETING Selling Costs and Demand Advertising and other selling efforts change the demand for a firm’s product. The effects are complex: A firm’s own advertising increases the demand for its product Advertising by all firms might decrease the demand for any one firm’s product and make demand more elastic. The price and markup might fall.

12.2 DEVELOPMENT AND MARKETING This figure (not in the textbook) shows the possible effect of advertising. With no advertising, demand is low but the markup is large.

12.2 DEVELOPMENT AND MARKETING With advertising, average total cost increases and the ATC curve becomes ATC 1. Demand decreases and becomes more elastic. Profit maximizing output increases, the price falls, and the markup shrinks.

12.3 OLIGOPOLY Another market type that stands between perfect competition and monopoly. Oligopoly is a market type in which: A small number of firms compete. Natural or legal barriers prevent the entry of new firms.

12.3 OLIGOPOLY  Collusion When a small number of firms share a market, they can increase their profit by forming a cartel and acting like a monopoly. A cartel is a group of firms acting together to limit output, raise price, and increase economic profit. Cartels are illegal but they do operate in some markets. Despite the temptation to collude, cartels tend to collapse.

12.3 OLIGOPOLY To study oligopoly, we look at the simplest case, duopoly, which is a market in which there are only two producers.  Duopoly in Airplanes Airbus and Boeing are the only makers of large commercial jet airplanes. How do these firms decide how many planes to produce and what the price of an airplane will be?

12.3 OLIGOPOLY Competitive Outcome Price equals marginal cost. Monopoly Outcome The firm would be a single-price monopoly. Possible Oligopoly Outcomes The extremes of perfect competition and monopoly provide the maximum range within which the oligopoly outcome might lie.

12.3 OLIGOPOLY

 The Duopolists’ Dilemma By limiting production to the monopoly quantity, the firms can maximize joint profits. By increasing production, one firm might be able to make an even larger profit and force a smaller profit on to the other firm. The duopolists’ dilemma is whether to limit production or increase it.

12.3 OLIGOPOLY Joint profits can be $72 million if the firms produce the monopoly output.

12.3 OLIGOPOLY Boeing can increase its economic profit by $4 million and cause the economic profit of Airbus to fall by $6 million. Boeing Increases Output to 4 Airplanes a Week

12.3 OLIGOPOLY Airbus Increases Output to 4 Airplanes a Week For Airbus this outcome is an improvement on the previous one by $2 million a week. For Boeing, the outcome is worse than the previous one by $8 million a week.

12.3 OLIGOPOLY Boeing Increases Output to 5 Airplanes a Week If Boeing Increases output to 5 Airplanes a week, its economic profit falls. Similarly, if Airbus Increases output to 5 Airplanes a week, its economic profit falls.

12.3 OLIGOPOLY The dilemma: If both firms stick to the monopoly output, they both produce 3 airplanes and make $36 million. If they both increase production to 4 airplanes a week, they both make $32 million. If only one increases production to 4 airplanes a week, that firm makes $40 million. What do they do? Game theory provides an answer.

12.4 GAME THEORY Game theory The tool used to analyze strategic behavior— behavior that recognizes mutual interdependence and takes account of the expected behavior of others.

12.4 GAME THEORY  What Is a Game? All games involve three features: Rules Strategies Payoffs Prisoners’ dilemma A game between two prisoners that shows why it is hard to cooperate, even when it would be beneficial to both players to do so.

12.4 GAME THEORY  The Prisoners’ Dilemma Art and Bob been caught stealing a car: sentence is 2 years in jail. DA wants to convict them of a big bank robbery: sentence is 10 years in jail. DA has no evidence and to get the conviction, he makes the prisoners play a game.

12.4 GAME THEORY Rules Players cannot communicate with one another. If both confess to the larger crime, each will receive a sentence of 3 years for both crimes. If one confesses and the accomplice does not, the one who confesses will receive a sentence of 1 year, while the accomplice receives a 10-year sentence. If neither confesses, both receive a 2-year sentence.

12.4 GAME THEORY Strategies The strategies of a game are all the possible outcomes of each player. The strategies in the prisoners’ dilemma are: Confess to the bank robbery Deny the bank robbery

12.4 GAME THEORY Payoffs Four outcomes: Both confess. Both deny. Art confesses and Bob denies. Bob confesses and Art denies. A payoff matrix is a table that shows the payoffs for every possible action by each player given every possible action by the other player.

12.4 GAME THEORY Table 12.5 shows the prisoners’ dilemma payoff matrix for Art and Bob.

12.4 GAME THEORY Equilibrium Occurs when each player takes the best possible action given the action of the other player. Nash equilibrium An equilibrium in which each player takes the best possible action given the action of the other player.

12.4 GAME THEORY The Nash equilibrium for Art and Bob is to confess. Not the Best Outcome The equilibrium of the prisoners’ dilemma is not the best outcome.

12.4 GAME THEORY  The Duopolists’ Dilemma as a Game Each firm has two strategies. It can produce airplanes at the rate of: 3 a week 4 a week

12.4 GAME THEORY Because each firm has two strategies, there are four possible combinations of actions: Both firms produce 3 a week (monopoly outcome). Both firms produce 4 a week. Airbus produces 3 a week and Boeing produces 4 a week. Boeing produces 3 a week and Airbus produces 4 a week.

12.4 GAME THEORY The Payoff Matrix Table 12.6 shows the payoff matrix as the economic profits for each firm in each possible outcome.

12.4 GAME THEORY Equilibrium of the Duopolists’ Dilemma Both firms produce 4 a week. Like the prisoners, the duopolists fail to cooperate and get a worse outcome than the one that cooperation would deliver.

12.4 GAME THEORY Collusion is Profitable but Difficult to Achieve The duopolists’ dilemma explains why it is difficult for firms to collude and achieve the maximum monopoly profit. Even if collusion were legal, it would be individually rational for each firm to cheat on a collusive agreement and increase output. In an international oil cartel, OPEC, countries frequently break the cartel agreement and overproduce.

12.4 GAME THEORY  Repeated Games Most real-world games get played repeatedly. Repeated games have a larger number of strategies because a player can be punished for not cooperating. This suggests that real-world duopolists might find a way of learning to cooperate so they can enjoy monopoly profit. The larger the number of players, the harder it is to maintain the monopoly outcome.